Tax-managed funds back in the spotlight

The tax-exempt status of municipal bonds, which makes them particularly attractive to high-net-worth investors, is up in the air as Congress wrestles with the fiscal cliff.

“This election makes the administration's proposal for a 28% cap much more plausible,” Matt Posner, legislative coordinator at Municipal Market Advisors Inc., said at the Bloomberg event.

Any changes to the tax status of the bonds could send notoriously fickle muni bond fund investors fleeing for the exits.

“There's going to be a negative reaction [to a change in the tax-exempt status of munis] and it could lead to sustained redemptions,” said Peter Coffin, president of Breckinridge Capital Advisors Inc.

Muni bond investors have shown that they are susceptible to factors that have nothing to do with the underlying fundamentals of the market.

In late 2010, for example, well-known analyst Meredith Whitney, founder of an eponymous research firm, triggered a massive sell-off in the market when she predicted a near-apocalyptic scenario for the asset class. To date, the raft of defaults Ms. Whitney predicted has failed to materialize.

Because performance of muni bond funds is largely tied to asset flows, sustained withdrawals would mean sustained losses in the funds, which generally are not liquid investments. That illiquidity could get even worse if the tax exemption were threatened, as it would make the narrow investor base even narrower.

“If you start limiting the exemption, you're only going to make the market less efficient and more vulnerable,” Mr. Coffin said.